New 3.8 percent Medicare surtax: a possible boon to the life insurance industry

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.

As a result of the new surtax, life insurance products are likely to play an expanded role in income tax planning for high income taxpayers.

The new health care legislation brings with it a tax increase. Beginning in 2013, individuals with net investment income may be subject to a 3.8 percent tax on the lesser of two amounts:

The individual’s net investment income; or

The excess of the individual’s modified adjusted gross income over the applicable threshold ($200,000 for individuals; $250,000 for joint filers).

Net investment income

Net investment income (NII) includes four broad categories:

Interest, dividends, non-qualified annuities, royalties and rents

Income from a business in which the taxpayer does not materially participate

Business income from trading in financial investments or commodities (whether or not the taxpayer materially participates)

Gains from the sale of property

Exempt from the new tax is self-employment income, active trade or business income, gain on the sale of an active interest in a partnership or S corporation, and IRA and qualified plan distributions.

Modified adjusted gross income

Modified adjusted gross income (MAGI) is basically adjusted gross income (AGI) and, except for U.S. citizens or residents who live abroad, MAGI and AGI will almost always be the same. MAGI does not include tax exempt income, excluded gain on the sale of a principal residence, or non-taxable distributions from a Roth IRA. However, required minimum distributions from an IRA or qualified plan and income recognized on a Roth IRA conversion are included in MAGI.

Strategies to avoid the surtax

There are two ways to minimize the impact of the new surtax: reduce NII or reduce MAGI. Note that reducing NII automatically reduces MAGI. One way to reduce NII is to invest in a tax-deferred annuity and postpone taking distributions from the annuity until those years when the distributions will not produce any surtax (because of the threshold amounts). Until distributed, the inside build-up of the annuity is not considered NII.

A similar strategy is to invest in a permanent life insurance policy. The owner/insured could then withdraw basis (or borrow against the policy’s CSV). In either case, the surtax will not apply. Nor will the inside build-up of cash value be considered NII.

One strategy for reducing MAGI is to use a charitable remainder trust (CRT). The surtax does not apply to CRUTs or CRATs until the donor receives the unitrust or annuity payments from the CRT. This might enable the donor to avoid gain on the sale of an appreciated asset (without paying any surtax), and spread out MAGI to avoid having it exceed the threshold amounts. The trade-off, of course, is that charity must be given a remainder interest with a present value equal to at least 10 percent of the value of the property transferred to the CRT. But the donor can then use the income tax savings (i.e., an upfront charitable income tax deduction, no immediate capital gains tax and little or no surtax) to purchase a life insurance policy (inside an ILIT) to “replace” the wealth passing to charity.

As a result of the new surtax, life insurance products are likely to play an expanded role in income tax planning for high income taxpayers.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.